The term short-selling stock refers to the practice of selling securities that are not owned. Investors will short stocks when they believe a stock's market price is going to decline. In this article, we are going to cover the stock market investment strategy referred to as short selling.
We will explain the five steps involved with this technique, as well as the risks and rewards involved. We will also talk briefly about some speciality approaches, provide several examples, and finish up by discussing the ethical side of short selling.
What is short selling?
When an investor is selling a stock short, they have a negative or "bearish" outlook with respect to the price of the stock they're trading. Day traders and hedge fund managers will often sell short in an attempt to profit from falling prices on securities they believe are overvalued.
Stock exchanges will typically report the total number of shares of a security that have been sold short by investors, and that have not been repurchased to settle positions in the market.
This measure is referred to as short interest. This ratio is calculated by taking the monthly short interest volume on the entire stock exchange and dividing it by the average daily trading volume.
A high ratio normally indicates bearish feelings toward the market. On the other hand, bullish investors see a high ratio as a positive sign for the market's outlook. These investors believe that short-interest positions must eventually be covered, and the increase in demand for stocks necessary to cover open positions will drive the price of stocks back up.
- Profit from declining prices – Short selling allows investors to capitalize on decreasing stock prices and potentially generate profits when they correctly predict a decline in value.
- Hedging against market downturns – Short selling can act as a hedge for investors who already hold long positions in stocks, providing a means to offset potential losses during market downturns.
- Identifying overvalued stocks – Short sellers often conduct in-depth research to identify overvalued stocks or companies with underlying weaknesses, which can contribute to more accurate market pricing and help maintain market efficiency.
- Liquidity provision – Short sellers contribute to market liquidity by offering shares for borrowing, which can help facilitate efficient trading and price discovery.
- Unlimited losses – Unlike going long on a stock, short selling carries the risk of unlimited losses if the stock price rises significantly instead of declining as anticipated.
- Short squeezes – Short squeezes occur when heavily shorted stocks experience a rapid price increase, forcing short sellers to cover their positions by buying the stock at higher prices, leading to potential losses and increased volatility.
- Limited potential gain – Short sellers have a limited upside potential compared to going long on a stock.
- The maximum gain is limited to the initial amount shorted, as stock prices cannot fall below zero.
- Ethical concerns – Short selling is a controversial practice as it profits from declining prices and can be perceived as betting against companies and contributing to market instability.
Why do investors short-sell stocks?
The main reason to short stocks is to speculate on the price movement of an asset in a bid to turn a profit. The investor makes money from this strategy when the price of the stock they're borrowing declines.
These investors have a negative outlook on the security and anticipate the price of the stock will fall. In fact, "selling short" is the opposite of "going long", and normally when the seller borrows stock, the broker they're working with borrows the stock from an investor that is taking a long position.
In the United States, sellers must ensure their broker can make delivery of the securities. This is referred to as "locate", and brokers will not allow customers to short a stock before assuring that shares can be borrowed.
Opening a short position involves taking an exceptionally high risk in a bid to gain higher returns. In depressed markets, where difficult economic conditions challenge prospects of long-term economic growth, negative stock price movements provide opportunities for investors to make money by shorting stocks, or, in other words, bet that the stock prices will fall.
Shorting as a hedge
Shorting can also be a useful tool as a hedge against a possible downturn in the price of an asset held by investors. If an investor held shares in a particular company, and they were worried about a short-term fall in its stock price, they could open a short position to offset the fall in value of their existing stocks.
This way, the investor can avoid paying trading fees that would incur when selling and then buying the stock again.
Shorting against the box
"Shorting against the box" occurs when an investor sells short securities they already own. The name is derived from the thought of selling short the same securities that are held in a safe deposit box. The strategy can be suitable to use as a form of hedging against potential losses in a tax-efficient manner.
The strategy behind this approach is to lock in "paper" profits on the investor's long position, without having to sell the stock. If the price of the stock held by the investor increases or decreases, then the profits or loss on the short position are offset by the profit or loss on the long position.
The IRS views "shorting against the box" as a "constructive sale" of a long position, which triggers a taxable event unless certain conditions are met.
Which stocks are shorted the most?
The below table illustrates the 10 most shorted stocks listed on the New York Stock Exchange and NASDAQ, as of this writing.
| Carvana Co. | CVNA |
|---|---|
| Beyond Meat, Inc. | BYND |
| Big Lots, Inc. | BIG |
| Novavax, Inc. | NVAX |
| The Lovesac Company | LOVE |
| Trupanion, Inc. | TRUP |
| Editas Medicine, Inc. | EDIT |
| Upstart Holdings, Inc. | UPST |
| Fate Therapeutics, Inc. | FATE |
| The Children's Place, Inc. | PLCE |
How does short selling work?
The process of selling stocks short consists of the following five steps:
The investor borrows shares of the stock they are going to short. To do this, they need a margin account. Make sure to note that when an investor borrows stock, they’re promising to give back the stock at a future point in time.
To make the trade, the investor needs to deposit cash or show stock equity in the margin account. This will work as collateral, which should equal 50% of the short position’s value.
The stock that is borrowed is then sold, and the proceeds from the sale are deposited into the investor's brokerage account.
The investor patiently waits for the price of the stock to drop and then closes their position by buying back the shares. This is what is called covering their short position. The short position can be left open as long as needed, be it a few hours or a few weeks. One thing to remember is that investors have to pay interest on borrowed shares for as long as they hold them.
If the stock price falls as the investor predicted, they can close the short position by buying back the borrowed shares at a lower price, and return them to the broker or lender thereafter. Investors need to take interest, commission, and fees into consideration when calculating profit.
Trading options
What we described above is the process of traditional short selling, but it’s also possible to short stocks using stock market vehicles such as options.
Investors can buy a ‘put’ option, which would give them the right, but not the obligation, to sell the stock at a ‘strike’ price at any time before the expiry date of the option contract.
Say that Alphabet’s stock price currently stands at $150. Investors can buy a put option for 100 shares with a strike price of $120. If the stock price fell to $110, investors could buy 100 shares at this price, costing $11,000. They can then exercise the put option and sell the 100 shares at the predetermined strike price of $120, resulting in proceeds of $12,000, pocketing a profit of $1,000.
Buying a ‘short’ ETF
Shorting is also possible via inverse ETFs, which offer a way of inversely tracking an asset or index. An inverse ETF is set up so that its price rises (or falls) when the price of its target asset or index falls (or rises). In other words, it performs inversely to the asset it's tracking.
ProShares UltraShort S&P500, for example, shorts the S&P 500 index by a factor of two. This means that if it falls by 200 points, the ETF price will rise by 400 points, and vice versa.
A short-selling example for a profit
In this example, the investor is looking to borrow 100 shares of Company X stock, currently selling at $50 per share. The seller borrows the 100 shares of Company X from their broker and immediately sells the shares on the market for $50 per share, and makes $5,000.
Let's assume that at a future point in time, the price of Company X stock drops to $40 per share. The investor would then buy back the 100 shares of Company X at $40 per share, or $4,000, and make $1,000 in profit.
The theoretical limit of profitability in this example occurs if the price of Company X's stock falls to $0 per share. At that point, the investor purchases the stock of Company X for $0 and makes a profit of $5,000.
A short-selling example for a loss
Let's say an investor believes that the stock price of Company Y will decline. They borrow 200 shares of Company Z from their broker and sell them on the market at $50 per share, generating $10,000 in cash.
However, instead of the anticipated decline, the stock price of Company Y unexpectedly rises to $70 per share. The investor is now forced to buy back the 200 shares at a higher price, costing them $14,000.
In this case, the investor incurs a loss of $4,000 on the short-selling transaction because they had to buy back the shares at a higher price than they sold them for.
A short-selling example for hedging
Imagine an investor who owns 500 shares of Company Z and wants to protect against potential price declines. They decide to employ a short-selling strategy as a hedge.
The investor borrows 500 shares of Company Z and immediately sells them on the market at $80 per share, generating $40,000 in cash. If the stock price drops to $60 per share, the investor buys back the 500 shares at this lower price for $30,000. Meanwhile, the value of their original shares declines to $30,000.
In this scenario, the gain from the short position offsets the loss on the original shares, effectively hedging against the price decline. Alternatively, if the stock price rises to $100 per share, the investor still buys back the 500 shares at this higher price for $50,000. However, the value of their original shares also increases to $50,000, offsetting the loss.
By utilizing short selling as a hedge, investors can mitigate potential losses on their existing stock holdings when the market moves against their expectations. It's important to consider risks, borrowing costs, margin requirements, and market volatility when employing this strategy.
Understanding the risks of short selling
The biggest risk to short selling is the potential for unlimited losses. If that doesn’t sound offputting enough, we also list further considerations.
Unlimited losses
Since the investor is hoping the price of the borrowed security will fall, the biggest risk of taking this position is the price of the stock increases. If that occurs, and the investor is using a margin account, then a margin call will be made if the required maintenance is not met.
This can occur when the stockholder's equity position falls below a prescribed percentage. If the price of the stock remains at an inflated level, then the investor may eventually be forced to close out their position and realize a loss on the transaction.
Since there is no theoretical upper limit to a stock's price, the investor's loss is also without theoretical limits. Since the price of a stock cannot fall below $0 per share, the upper limit for profit is the total value of the stock sold short.
One strategy that traders use to limit their losses is to place a "stop loss order". When shorting a stock, the investor can issue what is called a stop-loss buy order at a set price. The order will be executed if the stock's price reaches the stop-loss price. When this happens, the short position on the stock is closed out, thereby placing a limit, or cap, on losses.
Short squeezes
A short squeeze occurs when there’s a rapid and significant increase in the price of a stock that has been heavily shorted. It puts pressure on short sellers to cover their positions by buying the stock, which further drives up the price, creating a cycle of forced buying.
Short squeezes are often fueled by a combination of positive news, market sentiment, and supply and demand dynamics, and they can be unpredictable and volatile. They also typically have a significant effect on both short sellers, who may suffer substantial losses if they are unable to exit their positions at a favorable price.
Less potential gain
More often than not, short sellers also have less potential gain than going long in the stock.
To illustrate, let’s compare the potential gain on buying 100 shares of a Company J stock trading at $100 per share. If the stock rises to $200, the investor would make $100,000 from their initial investment. If the stock prices continue to rise, they will make an additional $10,000 for every $100 rise in the stock price.
The value of a share can continue rising over the years if the company is well-run. There’s no upper limit to the upside potential of a stock.
Inversely, the potential gain for a short position is limited to the initial amount shorted. If an investor shorts 100 shares of Company J at $100 per share, the most they could gain is $10,000 in total, which would happen if the company goes bankrupt.
This shows that the most an investor can profit in a short position is the initial value of the stock they have shorted.
The ethics of short selling
Short selling has long been a controversial matter as it involves capitalizing on decreasing prices, leading many to perceive it as a stance that profits from failure rather than wagering on success. For many, this is an attack on the stock market itself. The central argument is that short-selling hedge funds bet against growth and force the prices of stocks down, which can lead to severe financial troubles for the shorted company.
It’s not wrong that some active short sellers are spreading rumors or opinions that try to discredit profitable companies and spook the market into selling their shares. This practice indeed hurts the company and its shareholders and leads their stock to be traded below its fair value.
Yet, on the flip side, short-selling can limit the rise of stocks and prevent them from going into a speculative run where prices are inflated without substance. Short sellers may identify flaws that were overlooked by many analysts or auditors, and by deflating prices, they can help maintain order in the market.
What are naked shorts, and why are they banned?
The technique known as naked short selling or "naked shorting" is the practice of selling a stock short without first borrowing the shares, or making an "affirmative determination" that the shares can be borrowed.
This practice violates US securities law. In January 2005, the Securities and Exchange Commission (SEC) enacted Regulation SHO to reduce the practice of naked short selling and the subsequent practice of "failure to deliver" securities.
Additional Resources
- Day trading is a challenging and often intimidating venture, as evidenced by the fact that a whopping 85% of day traders quit within the first three years. Despite this sobering statistic, we believe that selecting the appropriate tools can make a significant difference in a trader's success.
- Trading has never been easier, thanks to the rise of online platforms that enable you to buy and sell various assets at the click of a button. But with so many options available, it can be challenging to decide which platform is right for you.
- Our top beginner's pick for copy trading is eToro. Read on for more details, plus seven good alternatives.
- An option contract allows traders to buy (call) or sell (put) an underlying asset at a specific price on or before a designated date and hold the right to scrap the contract. The option holder (the trader who buys the contract) pays a premium to the options writer (the trader who sells the contract). Note that premiums are multiplied by $100, the multiplier for standard US equity options contracts. So an option's premium of $1 is really $100 per contract.
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